ZERO INTEREST RATE POLICY

A Brief Introduction, Comparison, and Possible Implications of Japanese and US ZIRP Commitments

Contents
Overview ....................................................................................................................................................... 3 Zero Interest Rate Policy (ZIRP) .................................................................................................................... 3 Liquidity Trap ............................................................................................................................................ 4 Post WWII Japan ........................................................................................................................................... 5 The Japanese Miracle ................................................................................................................................ 5 Finding a Competitive Advantage ......................................................................................................... 5 Market Consolidation............................................................................................................................ 6 Property Boom ...................................................................................................................................... 6 Ziatech ................................................................................................................................................... 7 BOJ Acts......................................................................................................................................................... 7 The Aftermath ........................................................................................................................................... 8 BOJ Commits to ZIRP ................................................................................................................................. 8 Differences in Japanese and US Post ZIRP .................................................................................................... 9 Japan Inc. ................................................................................................................................................ 10 Too Big to Fail ......................................................................................................................................... 10 Balance Sheets ........................................................................................................................................ 10 Japan is Old ................................................................................................ Error! Bookmark not defined. Tentative Review of US ........................................................................................................................... 12 ZIRP Risks to US and Others ........................................................................................................................ 12 ZIRP ..................................................................................................................................................... 13

Asset Bubbles .......................................................................................................................................... 13 External Shocks ....................................................................................................................................... 14 Unconventional Policy ............................................................................................................................. 14 Monetary Policy Fails .............................................................................................................................. 16 Customer Take Away .................................................................................................................................. 16

The opinions expressed are those of the author, Jesse Vaughn, and not necessarily that of FXCM.
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Overview In an effort to continue educating our clients about financial and economic forces, as well as inform them of the benefits of FXCM, this report explores the Zero Interest Rate Policies following the US and Japanese asset bubbles, structural problems associated with their burst, economic drags that confront recovery, as well as the inherent risk in pursuing historically unprecedented monetary policy.

Zero Interest Rate Policy (ZIRP) Zero Interest Rate Policy is a macroeconomic concept describing a condition in which nominal interest rates are approaching their lower bound, zero. Under this policy, the central bank commits to maintaining near zero nominal rates for an extended period of time. In order to affect the market equilibrium, the central bank uses monetary tools, such as overnight rates, in an attempt to put downward pressure on market rates. Once key rates hit this important lower bound they cannot be lowered further, otherwise a lender would essentially pay a borrower for taking out a loan. A central banks commitment to ZIRP is an important indicator. This is simply because once key interest rates reach their lower bound, they cannot be lowered further, and thus the central bank loses considerable leverage to stimulate demand for loanable funds by the manipulation of interest rates. As a result of this constraint, central banks have resorted to unconventional policies in an effort to reach specific policy targets. More on this in subsequent sections.
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Liquidity Trap Zero Interest Rate Policy shares some characteristics with a liquidity trap. In a liquidity trap, an increase in the money supply fails to lower market interest rates. Partly to blame for this could be the expectation of adverse events in the future, such as deflation, insufficient aggregate demand, or low expectations of business investment. These expectations can be triggered by an external shock to the economy, which causes individuals to hoard their money. This increase in aggregate savings, accompanied by a reduction in the demand for loanable funds, reduces the prevailing market interest rate. If the shifts are substantial enough, the central bank is left with little leverage to stimulate investment demand by lowering interest rates or increasing the money supply (refer to the graph below).

Investment SavingLiquidity Preference Model

In a liquidity trap, IS shifts down and to the left because decreased investment demand and increased savings. Thus, the demand for loanable funds decreases from where interest rates (i) are positive, to where they are negative. Further actions by the central bank to increase liquidity in the market (rightward shift of LM) will not lower interest rates, and as a result will not increase the demand for loanable funds. (Holding prices constant)

Many think Japan was in the midst of a liquidity trap after the bursting of the asset bubble. Investment demand fell as insolvent businesses opted to pay off their balance sheets,

rather than borrow and reinvest in capital goods. Historically good savers, Japanese households already supplied a good deal of money into the market for loanable funds. Further deflationary pressure, due to a positive trade balance, further complicated the BOJs efforts to stimulate demand. The commitment to a Zero Interest Rate Policy for over a decade with continual price deflation further points to a classic Liquidity Trap.

Post WWII Japan In an effort to further understand the causes and effect of Japans Zero Interest Rate Policy, we will take an historical look at the some of the structural forces that may have contributed to the subsequent bubble, and the commitment to ZIRP. The Japanese Miracle After World War II, the United States and its allies undertook efforts with Japan in order to rebuild and modernize its manufacturing sector. The mutual cooperation, along with the worry of Japan following others towards communism, led to an opening up of relations economically. This cozy relationship allowed Japan to benefit from the growing prosperity of the United States. Finding a Competitive Advantage Japan found its competitive advantage in manufacturing consumer goods cheaply, and more efficiently. Companies took advantage of emerging technology, further introduced value added innovation, and exported these goods to advanced economies at a cheaper rate than their Western counterparts. This competitive strategy, along government policies that fostered growth, allowed Japans wealth to continue to rise.

Market Consolidation Japans sudden introduction to western capitalism had some notable characteristics. Such a sudden transformation led to a handful of families accumulating vast amounts of wealth (much like Post Soviet Union Russia). This consolidated wealth allowed these families to build businesses that would eventually grab large portion of their respective industrys market share. These powerful firms eventually consolidated, which left a small number of companies holding large market shares in multiple industries. In an effort to promote friendly relations among businesses, as well as an expectation of promoting long term market stability, these companies created extensive webs of cross-holdings in other companies. This strategy of cross-holdings of shares among companies and industries was known as Ziatech, and it eventually led to a massively integrated collection of corporate assets among all sectors of the Japanese economy. Property Boom As the economy continued to expand, mountainous land caused a shortage of good commercial property and land prices appreciated dramatically, most notably in Tokyo. The loosening of banking regulations, as well as banks allowing land as collateral for loans, allowed companies and individuals to take advantage of this appreciating land value to easily obtain credit. The historically high level of saving rates of Japanese citizens, accompanied by an easing of monetary policy by the Bank of Japan, meant this easy credit was also cheap.
Due to land scarcity, property prices rose at amazing rates. The bursting of the equities bubble had a lagging drag on property prices, which began to fall from their peak in 1991.

Ziatech As companies property values allowed businesses to easily obtain cheap loans, they did so, but not always for capital investments. The practice of Ziatech, or cross holdings of other companies, let firms take advantage of the appreciating land values for cheap loans, and invest them back in equities. Further deregulation allowed businesses to report revenue from speculative investments as profits without clarification. These perfect conditions of cheap money, easy credit, and a booming equities market led to enormous increases in wealth. The Tokyo Stock Exchange rose from 30% GDP in the mid 1980s to over 140% of GDP by the 1989 peak (Refer to the graph on page 5). Some estimates suggest that 40-50% of Japanese corporate earnings were derived from this form of financial engineering.
Rising property prices allowed easy credit. Low interest rates allowed companies to easily profit from speculating on equities. This led to a perpetuation of overpriced assets, which would eventually crash in the 1990s

BOJ Acts Bank of Japan officials became concerned about rapidly rising property prices and took action by tightening monetary policy in 1990. Unfortunately, the BOJ was too eager to shake the excess demand in real estate and inadvertently crashed Japans stock markets. Market value plunged by 50% alone in 1990. This rapid decline in equities destroyed the revenue created by the financial engineering that many firms relied on. This elaborate cross holding
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from the practice of Ziatech would further exacerbate problems, as no industry was immune from the financial contagion. Mutual harm was ensured across industries. This was the beginning of the end of the three decades long Japanese Miracle. The Aftermath The collapse in the stock market would eventually translate into plummeting property prices. With large portions of Japanese wealth erased, profits from speculation rendered unrealistic, and adverse expectations for the future, Japanese banks were put in a tough situation. Banks now had an enormous accumulation of non-performing loans. Even worse, much of the outstanding credit from banks were to businesses they deemed as too big to fail, and continued to pump liquidity into these firms in hopes of reviving the failing businesses. Unfortunately, the vast majority of these so called Zombie Firms were too debt ridden to do much more than struggle along from bailout to bailout. Eventually, with the realization that continued bailout of these zombie firms was unsustainable, market consolidations took place, leaving only four national banks in Japan. Japanese firms were heavily indebted, which led many to use revenues to pay down their balance sheets as opposed to making capital investments. It also became increasingly difficult to obtain credit, which led rise to shadow lending as many companies turned to loan sharks. BOJ Commits to ZIRP

Currently the Japanese overnight call rate is 0%. The BOJ has adopted an interest rate target between 0-.1%, and nominal rates have been below 1% since 1995. Despite the seemingly accommodative policy, Japan has experienced deflation since the mid 1990s, and has only recently been able to achieve inflation due to extraordinary measures by the central bank. The Nikkei stock index now trades just over a quarter of its peak in 1990s, and residential real estate was reportedly worth only 10% of its all time high as of 2004. These factors, accompanied by a rapid deceleration in growth, gave rise to the popular moniker The Lost Decade.

Differences in Japanese and US Post ZIRP At first blush, there appears to be remarkable similarities between the US and Japanese bubbles. There was a remarkable build up in residential prices in the United States, similar to the appreciation of land prices in Japan. The financial engineering of Ziatech mirrors the subprime mortgages and derivatives in the States in many ways. There was even a huge increase in equity prices in the 1990s in the US, much like in Japan. When taken at face value, these crises seem very similar indeed. Here are side by side

comparisons of the residential/property values, as well as the 1990s stock indexes, of both Japan and the US. However similar these situations may seem at face value, there are striking differences in the structural problems leading up to each crisis. These unique characteristics, as well as government responses, are what differentiate the magnitude and extent of the recovery. Japan Inc. Japanese industry was much more concentrated when it comes to market share per industry than the US. In fact, the cozy relationship between these large corporations and the Japanese government is what sparked the nickname Japan Inc. These corporations financial engineering formed complicated networks that mutually assured throughout Japans industries. In the United States, this was far less of an issue. Too Big to Fail In America, the government did have to inject liquidity into companies. This took place in the banking industry, but as well a non-financial sector, the auto industry. These bailouts in the US do mirror actions in Japan, but the bailouts in the US were spasmodic, not systematic. That is, a onetime injection into these companies was enough to keep them afloat. In Japan, zombie firms needed continual liquidity, and were a drag on the economy for a long while as they struggled from bailout to bailout. Balance Sheets The rebalancing that needed to take place to take firms out of insolvency materialized far quicker in the US than in Japan. This is an important distinction because when firms opt to pay down their debt, they forego investment spending. US corporations now own huge levels of

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assets compared to liabilities. The trickier rebalancing that needed to take place in the United States was in mortgage contracts. As the housing bubble burst, prices dropped and left many individuals underwater. Restructuring mortgages, accompanied with raising demand and scarce supply of houses, may eventually resolve this issue. Aging Demographics There were substantial shifts in demographics that coincided with Japanese recovery efforts. The sharp decline in Japans growth rate seems to have much to do with an aging population exiting the work force with too few new entrants. In the mid 90s Japan began a

Japanese Population Pyramid shows the large shift in age demographics for the population. This will likely continue to be a structural problem in the future for Japan.

steady decline in the work force, a historic shift from its .9% rise per year to a decline of .3% per year in the following decades. In fact, if you adjust for the shrinking work force the economy actually grew 1.2% per working age person. The US does have a declining work force, but not nearly to the extent of Japan. This shrinking workforce will likely prove to be a problem for Japan for quite some time. Below are the aging demographic patterns for the United States for comparison. These trends point to a shrinking workforce, but not to the extent that Japan will likely face in the future.
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Tentative Review of US These differences, along with the rapid action taken by the Federal Reserve to shore up markets, seem to have steadied markets much quicker than Japan. This might all seem to point to a quicker recovery in the US than in Japan, barring external shocks to the economy. However, there are many factors that could pose problems to the US economy. The use of ZIRP has diminishing results, as evidenced with continued use of unconventional policy measures. The loss of leverage that accompanies a zero interest rate policy, along with the uncertainty inherent in such an untested and large scale commitment, leads the US into unfamiliar territory.

ZIRP Risks to US and Others While ZIRP has been implemented sparingly in the past with varied results, the magnitude of its current use is unprecedented. With six out of ten of the worlds largest economies targeting an overnight interest rate of .5% or less, future uncertainty is exacerbated from lack of precedent. Adverse events to macroeconomic conditions are heightened in the
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absence of complete information, as central banks are left without historical patterns as a guide to model future policy. Several possibilities of adverse events that may arise are briefly explained below. ZIRP Though the short term effects for banks and markets seem to be positive, continued use of this policy may yield diminishing returns to macroeconomic targets. Low interest rates also tend to result in a search for yield, which could contribute to overpriced assets in some markets. Poor management while unloading Fed balance sheets could lead to sharp volatility in overpriced markets, as well as in markets with heavy central bank intervention. The International Monetary Fund comments on the challenges in the eventual unwinding of ZIRP and QE below:
Central banks also face challenges in eventually exiting markets in which they have intervened heavily, including the interbank market; policy missteps during an exit could affect participants expectations and market functioning, possibly leading to sharp price changes. -IMF

Asset Bubbles With historically low interest rates, and no sure departure from ZIRP, commitments to prolonged low rates could result in price distortions in yields, due to investors searching for yield. A certain degree of risk and investment is usually healthy in a recovery situation, but without proper oversight bubbles could form. Further still, aggressive increases in interest rates could destabilize these markets, causing further economic risks.

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External Shocks With ZIRP firmly in place in 6 of the 10 largest economies, there is little leverage for many central banks other than to further pursue unconventional policies. If an unexpected shock to the economy occurs, central banks will not have the leverage they normally do with interest rates, the only tools they can use are unconventional. Unconventional Policy Many policies that central banks are implementing are untested, and may pose risk if they are not properly managed once unwinding of these balance sheets occurs. The increase in mortgage backed securities by the FED is listed below. Here are some of the extraordinary measures central banks have taken in the past few years: Prolonged periods of very low interest rates, sometimes contingent upon explicit macroeconomic targets Quantitative easing (QE), which involves direct purchases in government bond markets to reduce yield levels or term spreads when the policy rate is approaching the lower bound Indirect credit easing (ICE), in which central banks provide long-term liquidity to banks (sometimes with a relaxation in access conditions), with the objective of promoting bank lending Direct credit easing (DCE), when central banks directly intervene in credit markets such as through purchases of corporate bonds or mortgage-backed securitiesto lower interest rates and ease financing conditions (and possibly mitigate dysfunction) in these markets The following is a quote from the IMF Global Financial Stability Report on the risk associated with a change in composition of central bank balance sheets:

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These unconventional methods have led to a fundamental change in the size and composition of central bank balance sheets. Total assets have increased significantly, mostly in the form of government securities, bank loans, equities, and mortgage-backed securities. These shifts entailed specific (and new) risks for central banks, including credit and market risks. Unless they are adequately managed, including through enhanced loss-absorbing capacity, these risks (or perceptions about them) may affect the ability of central banks to perform their mandated roles and their credibility. If balance sheet assets are managed poorly, they could affect financial stability. The report goes on further about the risk from unloading balance sheet: Shifts in market sentiment may lead to sharp increases in yields. Uncertainty about the necessity or willingness of central banks to sell their large portfolios of government bonds and other assets could lead to shifts in market sentiment when central bank asset sales materialize. -International Monetary Fund

Below is an example 0f FED using unconventional policy in MBS.

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Monetary Policy Fails Monetary policy alone cannot create growth. It only has the power to indirectly effect variables that will stimulate output. For example, if banks refuse to lend their excess reserves, the increase in the monetary base will have little impact on the economy. The increased liquidity provided to the banks will remain stagnant, failing to reduce interest rates or increasing investment demand. Or, in the case of a liquidity trap, increases to the money supply could fail to translate into higher a demand for loanable funds. Furthermore, pressure for legislative responses to fix structural problems might be mitigated if accommodative monetary policy stimulates growth and masks underlying structural problems.

Customer Take Away Zero Interest Rates in 6 of the 10 biggest economies is unprecedented This lack of historical precedent augments the possibility of mistakes by central banks as there is no basis for future behavior IMF says pockets of overpriced markets can develop due to a search for yield, causing bubbles Overaggressive FED that raises interest too quickly could destabilize markets, causing sharp price declines in assets, deflationary pressure, or recession External shocks leave FED in a bind as it only has unconventional policies to stimulate growth Possible trouble with FED unloading its balance sheets Unconventional policies have left balance sheets fundamentally different for the FED

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IMF says the risks associated with fundamentally changed balance sheets could affect financial stability if not managed correctly

Monetary policy might not be effective enough, a liquidity trap can emerge if investment demand declines, emerging economies do not benefit from advanced economies currencies depreciating

Possibility of pesky inflationary pressures ZIRP can mask underlying structural problems that only legislation or regulation can fix Central Banks have no reference to gauge their actions. With so much uncertainty, and adverse possibilities, the most important thing for an investor to do is diversify.

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